TWN Info Service on Finance and Development (Mar10/02)
10 March 2010
Third World Network

Sovereign credit risks rattle markets – BIS
Published in SUNS #6875 dated 3 March 2010

Geneva, 2 Mar (Kanaga Raja) -- After ten months of substantial increases, equity prices in both advanced and emerging economies started falling from mid-January while credit spreads widened, as a result of several factors that include the unevenness of the global economic recovery, and concerns about sovereign credit risk in light of large fiscal deficits, particularly in Greece which spilled over to several other countries in the euro area, the Bank for International Settlements (BIS) has said.

In its latest quarterly review for March 2010, the Basel-based central bank for the world's central banks said that the rise in risky asset prices ran out of steam at the beginning of this year.

It attributes the apparent reduction of appetite for risky assets seen during much of the period under review to weak investors' confidence as a result of mixed news on the economic recovery in Europe and the United States. The unevenness of the global economic recovery added to the uncertainty.

Moreover, said BIS, concerns about sovereign credit risk intensified as market participants increasingly focused on the fiscal woes of Greece. These worries spilled over to a number of other countries in the euro area, and generally intensified the downward pressure on prices of risky assets. These sudden market pressures served as a warning about the financial risks of prolonged fiscal deficits.

Against this backdrop, the euro fell significantly against other major currencies. In addition, market interpretations of steps and future plans to normalise very expansionary policies seemed to amplify investors' unwillingness to take on risk. Global equity prices fell following decisions by the Chinese authorities to raise the reserve requirement ratio for large depository institutions.

[In a post on 1 March on the "Baseline Scenario" blog, Peter Boone and Simon Johnson, referring to the European Union - led by France and Germany - having some sort of financing package in the works for Greece, said that the main goal seems to be to "buy time - hoping for better global outcomes - rather than dealing with the issues at any more fundamental level."

[According to them, Greece requires 30-35 billion euro to cover its funding needs for the rest of 2010. "But under their current fiscal plan, we are looking at something like 60 billion euro in re-financing per year over the next several years - taking their debt level to 150 percent of GDP; hardly a sustainable medium-term fiscal framework," said Boone and Johnson. A fully credible package would need around 200 billion euro to cover three years, they added, noting that the German government would not be able to sell that to its voters.

[Boone and Johnson further said that the bailout package was really just an opportunity for European banks to get out of the Greek debt. "The Greeks can't really collapse until they lose access to funding, so the hope is that this prevents the problems from spreading - and the prospects of such a 'rescue' will keep bond yields down for Portugal, Spain and others," they said in their blog post.

[Their baseline view was that Greece would enter into a bad recession this year, and that their banks and corporations would have trouble raising financing, thus causing broader liquidity issues. "And it all comes to a head again as we near the time the government needs to take ever harsher measures next year, when there is again no bilateral funding in place. This is the new Greek cycle," they said.]

According to the BIS review, bond yields rose and equity prices fell after the US Federal Reserve announced an increase in the discount rate in the second half of February. While prices of risky assets generally continued to rise until around mid-January 2010, a broad-based pullback subsequently took place. Equity prices fell throughout the major advanced economies and larger emerging markets.

According to the Basel-based bank, towards the end of the period under review (from December 2009 to mid-February 2010), markets stabilised and recovered some of these losses. Still, by 17 February, stock indices in both advanced and emerging economies were more than 5% lower on average than their local peak levels in mid-January.

These declines were, however, relatively minor compared with the surge in equity prices seen since early March 2009, which - up until mid-January - amounted to around 55% in the advanced economies and 85% in the emerging markets. Credit markets were also affected, with spreads widening across the board. Commodity prices, which had risen strongly throughout much of 2009, fell back in tandem with other markets, but recovered somewhat towards the end of the period, said BIS.

"Perceptions of greater uncertainty about future market price developments and higher aversion to risk among investors were important ingredients in recent market dynamics."

Implied equity index volatilities, which by around mid-January had dropped to their lowest levels since the Lehman collapse (September 2008), subsequently spiked up by about 5-10 percentage points in advanced as well as emerging market economies, before decreasing again gradually in February. In credit markets, implied CDS (credit default swaps) index volatilities edged upwards from mid-January after almost a year of more or less steady declines.

According to BIS, concerns about the market implications of large fiscal deficits came to the fore in late 2009 and early 2010. Investors' attention was first drawn to the issue of sovereign risk by the financial difficulties encountered by the government-owned Dubai World in late November. More recently, the focus has shifted to the euro area, where large budget deficits led to the prospect of rapidly increasing government debt/GDP levels in several countries.

"Worries about the difficult fiscal situation in Greece, soon followed by similar concerns about Portugal and Spain, led to much wider credit spreads in both bond and CDS markets for these sovereign borrowers".

The credit spreads for some other euro area sovereign borrowers also rose. The more pronounced spread widening for Greece and, to a lesser degree, Portugal clearly reflected more imminent investor concerns. In contrast, Irish, UK and US spreads have changed little over recent months.

"Activity in the CDS market for developed country sovereign debt increased significantly as investors adjusted their exposure to sovereign risk," said BIS, noting that this market was virtually non-existent only a few years back, when sovereign CDS were mostly on emerging market economies, but has since grown rapidly.

This increase in activity resulted in significantly higher outstanding volumes of CDS contracts. Nevertheless, the amount of sovereign risk which is actually reallocated via CDS markets is much more limited than the gross outstanding volumes would suggest. Net CDS positions on Portugal amounted to only 5% of outstanding Portuguese government debt. For other countries, including Greece, the ratio of sovereign CDS contracts to government debt was even lower, said BIS.

Investor attention, BIS said, was first drawn to the fiscal situation in Greece in October 2009, when it became clear that the budget deficit for 2009 would be significantly higher than expected. This prompted rating agencies to reassess the outlook for Greek public finances.

The review pointed to the rating agencies Moody's, Fitch and S&P downgrading the Greek government debt, and the lowering of Greece's sovereign rating was accompanied by rating cuts for a number of Greek banks. The combined impact of these downgrades was clearly visible in equity markets, where equity prices for major Greek banks declined by almost 20% in one week.

One concern, according to BIS, was that Greek banks - which, according to analysts and rating agencies, depended more on ECB (European Central Bank) funding than institutions in other countries did - would no longer be able to post Greek government bonds as collateral in the ECB's refinancing operations.

[BIS data, as well as other media reports, indicate that a number of euro-area banks, including German and French banks, hold Greek bonds, which they have parked as collateral at the ECB to borrow euros for liquidity.]

At present, the ECB requires a minimum rating of BBB- for its collateral, but the ECB has indicated that it is likely to revert to the pre-crisis level of A- at the end of the year. The current A2 rating from Moody's ensures that Greek government bonds would still be acceptable as collateral even after such a change, but this would no longer hold in the case of further downgrades.

The possible loss of this funding source for Greek banks pushed up CDS premia and yield spreads on Greek government debt even further, as it increased the perceived financial risks for the government. On 25 January, the Greek government sold 8 billion euro of five-year bonds at 380 basis points above German government bonds and 30 basis points above similar outstanding Greek government bonds. The issue was highly oversubscribed, with bids totalling 25 billion euro.

"This was viewed as a positive development by investors, and resulted in a brief drop in the CDS premia. The respite was, however, only temporary. Despite new plans to cut the budget deficit and other efforts by policymakers to reassure markets, investor confidence remained fragile," said BIS.

Market reactions, BIS said, were not confined to Greece. By late January, there were clear signs of spillover effects to other markets as stock prices of European banks declined and sovereign spreads widened for a number of other European countries. Portugal and Spain were the most directly affected, but the impact was felt more broadly.

Equity prices fell around the globe and corporate credit spreads increased, while safe haven flows pushed down the government bond yields of several major countries. Sovereign credit spreads on a number of other countries widened. The sovereign CDS index for western Europe (which measures the cost of insuring against the risk of default for a basket of western European sovereigns) rose above 100 basis points for the first time amid increased activity in the sovereign CDS market.

The growing unease also weighed on the euro, which by early February had declined against other major currencies to levels not seen since early or mid-2009. Markets did, however, calm down in the weeks that followed, leading to a fall in Greek, Portuguese and Spanish credit spreads from their previous highs.

"Nevertheless, uncertainty remained despite EU governments pledging 'determined and coordinated action' to ensure financial stability in the euro area. This uncertainty was perhaps most clearly reflected in continued high sovereign credit spreads for a number of euro area countries," BIS further said.

Investor concerns about sovereign exposures weighed on banks' equity prices in late 2009 and early 2010, particularly in Europe. That said, bank credit spreads and equity prices also reflected financial statements posted in January and February that continued to report positive, albeit moderate, profits.

Sovereign risk had the strongest impact on equity prices and credit spreads for banks in Greece, Portugal and Spain, but other euro area banks were also affected, said the review, pointing out that an important aspect was the extent to which a bank was exposed to Greek, Portuguese or Spanish sovereign risk.

"Overall, BIS data suggest that euro area banks are markedly more exposed than non-euro area institutions to the public sector debt of these countries."

Market reaction to new information on the likely post-crisis regulatory framework for banks was mixed. On 17 December, the Basel Committee on Banking Supervision (BCBS ) published an important set of proposals designed to strengthen the sector's resilience.

Analysts took these proposals to mean that banks would be required in future to operate with more capital and less leverage. In principle, this would in the long run reduce their return on equity but also diminish the credit risk. However, added BIS, the immediate impact on bank equity prices and credit spreads was slight. European banks, thought to be more affected by simple limits on leverage, saw a brief dip in their stock prices after the announcement. Meanwhile, stock prices for US banks, which are already subject to such limits, hardly moved at all.

The review noted that a speech given by US President Barack Obama on 21 January elicited a more notable market response. The proposals - quickly labelled the "Volcker rule" - envisaged that commercial banks with a large deposit base should face limits to their proprietary trading and similar activities. The proposals also provide for limits on the size of individual firms relative to the overall system.

The shares of large banks with significant earnings from US financial market activities, whether or not they were headquartered in the United States, tended to weaken. In contrast, equity prices for US regional banks - which rely less on earnings from financial market activities - were less affected.

The review also highlighted the fact that a number of emerging market countries took initial steps to tighten monetary policy or signalled that such steps were forthcoming. This reflected increased credit expansion and growing inflationary pressures amid brisk economic growth. It also demonstrated that the recovery in these countries was well ahead of the cycle in mature economies.

In some countries such as China and India, a strong expansion of bank credit combined with rising asset prices prompted monetary tightening. The People's Bank of China (PBC) announced on 12 January that it would raise the renminbi reserve requirement ratio for large depository financial institutions by 50 basis points. Following the announcement, the Shanghai Composite Index fell by 2.3%. One month later, the PBC announced a second tightening of the reserve requirement, again of 50 basis points.

While Chinese stock markets were closed at the time for the Chinese new year holiday, equities elsewhere dropped significantly following this news. On 29 January, the Reserve Bank of India announced that it was increasing banks' cash reserve ratio by 75 basis points, in order to reduce excess liquidity and help anchor inflation expectations.

In addition to these moves, market analysts expected short-term interest rates to rise significantly in these and other major emerging economies. "Nevertheless, the timing of possible interest rate hikes still remained uncertain. A key complication in this regard is the risk that rising interest rates might have destabilising effects in those countries where capital inflows are already high."

In recent months, by contrast, market participants generally revised their expectations about monetary policy in major mature economies such that rate hikes were expected to occur later or at a slower pace than previously thought. This was partly because major central banks continued to signal that interest rate increases were not to be expected in the near term. Moreover, investors' policy expectations also reflected a perception that the recovery in major advanced economies was still in its early stages, the Basel-based bank added.

With investor confidence on the retreat, market participants were more sensitive to unfavourable than to positive economic news. In the United States, recent labour market figures were seen as less encouraging than markets had anticipated: initial jobless claims remained stubbornly high and non-farm payrolls continued to decline, albeit at a much reduced pace. Moreover, although fourth quarter US real GDP growth surprised on the upside, consumer spending growth, viewed as an important ingredient for the recovery in the United States, slowed to an anaemic 0.1% in the last month of 2009.

Europe also saw its share of weak economic data. Retail sales and industrial production figures fell short of expectations, and fourth quarter GDP figures were weaker than expected in the euro area and the United Kingdom, triggering declines in European equity prices and benchmark bond yields following the release of these statistics.

In line with investors' monetary policy expectations, the inflation outlook remained benign. Survey data pointed to well contained inflation expectations in the United States and in the euro area, both in the near term and over longer horizons. The pricing of inflation swap contracts seemed to be broadly consistent with this information. Both long-term spot and distant forward break-even rates had gradually risen in the course of 2009, as market conditions normalised.

"However, at the beginning of 2010, these rates dipped downwards again. Hence, despite unprecedented monetary and fiscal stimulus in recent months, market participants showed few signs of concern that long-term inflation expectations might become unanchored," said BIS.

Expectations that exceptionally low policy rates would prevail for some time in major developed economies meant that banks and other investors could continue to exploit cheap funding and invest in higher-yielding assets. In fixed income markets, yield curves remained extraordinarily steep, highlighting the potential profit from investing long-term with short-term financing.

According to BIS, the taking of such positions may also have contributed to recent downward pressure on long-term yields. Implied volatilities on interest rate derivatives contracts declined further, suggesting that the perceived risk associated with such investments continued to drop.

The combination of higher returns and lower risk meant that such positions were gaining in attractiveness from a risk-adjusted perspective too. Notably, measures of "carry-to-risk", which gauges return in relation to a risk measure, reached new highs for this type of position, said BIS.

It noted that further improvements in the functioning of financial markets, and, in particular, in money market conditions, meant that monetary authorities were able to gradually continue withdrawing extraordinary support.

In late January, a number of major central banks announced that they would discontinue the temporary liquidity swap lines with the Federal Reserve on 1 February. The ECB conducted its last 12-month refinancing operation in mid-December 2009 and decided to carry out its last six-month operation at the end of the first quarter of 2010. The US Federal Reserve proceeded with the planned closing of the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility and the Term Securities Lending Facility on 1 February.

The scaling-back of extraordinary measures also extended beyond liquidity support schemes; the Federal Reserve confirmed plans to end the process of purchasing $1.25 trillion of agency mortgage-backed securities and $175 billion of agency debt by the end of the first quarter, and to wind down its Term Auction Facility and the Term Asset-Backed Securities Loan Facility in the course of the first half of 2010.

Meanwhile, the Bank of England's Monetary Policy Committee decided in early February not to increase the Bank of England's programme of asset purchases beyond the total of 200 billion Pounds Sterling that had already been completed.

According to BIS, this scaling-back of supportive monetary measures was widely anticipated, in line with earlier announcements or signalling by central banks. As a result, it had no significant impact on asset prices.

However, investors did react to new statements about possible future policy action. Specifically, UK gilt yields fell sharply on 10 February - by as much as 10 basis points at the short end of the maturity spectrum - following remarks by the Governor of the Bank of England that it was "far too soon" to conclude that no further central bank purchases will be needed in Sterling bond markets.

On the same day, Federal Reserve Chairman Ben Bernanke mentioned in testimony to Congress that an increase in the spread between the discount rate and the target federal funds rate might be considered "before long", and he discussed the sequence of steps that the Federal Reserve might follow to exit from its very accommodative policy stance. Following these statements, US Treasury yields rose by some 5 basis points across the curve.

Despite this signalling, markets were surprised by the Federal Reserve's 18 February announcement of a 25 basis point increase in the discount rate, which was intended as a step towards further normalising its lending facilities. After the announcement, bond yields rose and equity prices fell, BIS added.

Meanwhile, in a special feature in the quarterly review on the architecture of global banking, which analyses the stability of banks' exposures to borrowers in six host regions, the authors found that local positions proved to be more stable during the crisis than those funded across borders and currencies, especially in emerging markets.

The special feature characterises banks by the structure of their foreign operations, and identifies a gradual long-term trend towards local banking. It also observes a persistent diversity in banks' underlying funding models that left some banks more vulnerable to the global funding disruptions during the crisis. +